Dodging the Steamroller: Fundamentals versus the Carry Trade

Although, according to uncovered interest rate parity, exchange rates should move so as to prevent the carry trade being systematically profitable, there is a vast empirical literature demonstrating the opposite. High interest currencies more often tend to appreciate rather than depreciate, as noted by Fama (1983). In this paper, we treat volatility as the critical state variable and show that positive returns to the carry trade are overwhelmingly generated in the low-volatility "normal" state, whereas the high-volatility state is associated with lower returns or with losses as currencies revert to the long run level approximated by their mean real exchange rate – in other words, purchasing-power parity (PPP) tends to reassert itself, at least to some extent, during periods of turbulence. We confirm these results by comparing the returns from three possible monthly trading strategies: the carry trade, a strategy which is long the undervalued and short the overvalued currencies (the "fundamental" strategy) and a mixed strategy which involves switching from carry trade to fundamentals whenever volatility is in the top quartile. The mixed strategy generates positive returns greater than for either of the pure strategies.